Continued Bear Markets Do Not Hurt the Case for Social Security

About the Author

Critics of Social Security reform claim
that the stock market's recent poor performance shows that
introducing personal retirement accounts into the Social Security
system would be unwise. They are wrong. Even with recent market
losses, such accounts would vastly outperform Social Security over
time. Moreover, because, as an individual nears retirement,
investment portfolios tend to become more diversified with higher
proportions of less volatile instruments, such accounts would be
less sensitive to market changes than a portfolio that is composed
solely of stocks.

Morningstar, Inc., an independent market
data and analysis firm, estimates that the value of mutual funds
invested in diversified U.S. stocks declined 12.1 percent during
the second quarter of 2002. However, not all types of investments
went down. Mutual funds containing the lower-risk instruments such
as taxable bonds, which are routinely held by those nearing
retirement, rose an average of 1.4 percent over that same period,
while funds invested in tax-exempt bonds rose 3.2 percent. Series I
U.S. Savings Bonds (I Bonds) also saw positive results and will pay
2.57 percent annually (2.0 percent after inflation) through
November 1. Thus, even with recent stock fluctuations, the
long-term prospects for earnings in personal retirement accounts
remain strong.1

The
recent poor performance of stocks must also be considered against
the high earnings of 1997-1999 and expected future positive returns
of investments generally. The return on a prudently mixed portfolio
of 50 percent stock index funds and 50 percent government bonds
could average 5 percent annually.2

In
contrast, a 35-year-old man with average earnings for his age group
can expect to "earn" a -0.3 percent return on his Social Security
retirement taxes. That is, after paying about $282,000 in taxes
over his career, he can expect only $262,000 in benefits. His
32-year-old wife would see a positive rate of return of 1.9 percent
annually--still well below even what I Bonds would pay.

Investment Risks Can Be Reduced

In
the real world, retirement investments have risk-limiting features
to reduce losses from market fluctuations. Such safeguards could be
part of Social Security personal retirement accounts as well by
incorporating the following features.

Different
portfolios for older and younger investors. Today,
investment advisers regularly structure retirement accounts so
that, as workers age, more funds are shifted into fixed-income
investments. Through this process, they tend to lock in earnings by
decreasing the proportion of investment in stocks. A recent survey
of 401(k) plans shows that, compared to investors in their
twenties, investors in their sixties invest less of their
portfolios in equity funds (44 percent vs. 63 percent) and much
more (23 percent vs. 8 percent) in guaranteed investment contracts
and similar instruments that pay a fixed interest rate. This model
can be applied to Social Security personal retirement accounts as
well.

This practice is significant because
decreasing the proportion of investment in stocks reduces the
potential for short-term loss. Although younger investors need to
invest most of their assets in stocks to get higher returns, those
who are closer to retirement need to reduce the likelihood that a
sudden market shift will affect them. In the second quarter of
2002, older investors nearing retirement whose money was invested
40 percent in stocks and 60 percent in tax-exempt bonds would have
seen their assets decline only by about 2.9 percent.

Index-type funds
rather than individual stocks. Stock index funds that
track the entire market are much less volatile than individual
stocks and funds that track only one economic sector. On August 21,
2002, Standard & Poor's 500 index rose by 1.3 percent, while
Pure Resources, Inc., stock increased by 34.2 percent and Radio
Shack stock declined by 16.4 percent. Although individual stocks
come and go and individual companies that make up an index change
frequently, the index remains more stable.

Long-term
investments in stocks. Retirement investors should be
encouraged to buy and hold stocks for long periods; thus,
legislation creating personal retirement accounts should discourage
short-term trading. Though stock returns fluctuate widely from year
to year, earnings on stocks held for 20 years or more have always
gone up. This is significant because retirement assets are usually
held for 20 to 40 years. The investment analysis firm of Ibbottson
& Associates has found that, since 1926, large company stocks
have had returns that varied from +53 percent in 1954 to -43
percent in 1931; when the same stocks were held for 20 consecutive
years, they had positive average annual returns, even when the
Great Depression was included in the period considered. Holding
stocks longer is even better. Jeremy Siegel of the Wharton School
at the University of Pennsylvania found that, since 1871, stocks
held for 30 years have always outperformed bonds and Treasury
bills.3

Blended
portfolios to smooth out risk and returns. Funds managers
should allow workers to invest their retirement account funds in
mixed portfolios of stocks and other investments. Such portfolios
would ease concerns about market fluctuation, since some money
would be invested in safer income instruments. As the demand for
retirement investment and annuity products grows, new instruments
that combine reduced risk with higher returns are being developed.
One securities firm has developed an inflation-indexed annuity with
a survivor's benefit. Insurance companies are developing packages
that include both investments and life insurance. Any of these
products would be suitable for personal retirement accounts.

Series I Bonds
or similar investments. Legislation creating personal
retirement accounts also should allow workers who wish to avoid any
risk to invest in U.S. Treasury Series I Savings Bonds, which
currently pay 2 percent plus inflation and have no administrative
charges.

Conclusion

Retirement investing is different from day
trading. It should consist of long-term investments that allow
relatively brief downturns to be balanced by more frequent positive
returns. Stock investments held for 20 years or longer always have
positive average annual returns. The recent stock market losses do
not change this fact.

Social Security pays extremely low rates
of return and faces significant financial problems. Even with
market fluctuations, workers could expect to earn significantly
more from personal retirement accounts than they could expect from
Social Security, accumulating a nest egg for retirement or to pass
on to their families.

It
has been said that choosing between higher risk and higher returns
is like choosing between eating better or sleeping better. Allowing
workers to invest some of their existing Social Security taxes in
their own personal retirement accounts would enable them to do
both.